Consolidation is an integral part of the market. Break out of a consolidating market could push the prices of stocks and indices very high in a very short time.
While on one hand it is very confidence boosting to know that directional move has taken place on the upside, one the other hand we also get a feeling that we have already run up too much.
As a result, after a big move we always want to prepare for 2 things.
1. A scenario where there is a tiny pullback before current up move continues
2. If this break out turns out to be a failure
In both these situations one thing that is always going to save us is the discipline of keeping a stop loss. So, stop loss in a long Futures trade is anyways a must. However, there is a solution to handle 2 out of the 3 possible directional outcomes that may not benefit us, which are small pullbacks or further consolidation.
The solution is all covered. We will see how to construct a covered call strategy and its benefits.
How?
We buy a Futures contract to profit from an upside. With Covered Call we just need to add a Sell position in Call to this Future. Expiry remains the same for the Call option. Strike Price is usually the short-term Target level.
For Example:
Buy Future @ 100
With 106 as immediate target
Sell Call 107.5 CE
Impact of additional Call on the Buy Futures Trade:
1. We receive a premium so that the cost of trade goes down. This means profit will be more and losses will be lesser by the amount of premium earned.
2. We will not be able to make more money out of this trade for a move over Call Strike Price. In our example. No profits for a move above 107.5
Benefits:
1. Since we Bought after a big move. Probability of big moves back-to-back is low. So, in case if the stock consolidates a little bit, drop in premium of our sold Call due to passage of time will help
2. In case, if this turns out to be a wrong trade and a reversal comes around, the drop in premium of our Sold Call due to fall in price of the underlying will help us reduce the loss
Ultimately, we will be able to make money from a fairly high probability scenario that there may not be a big move immediately after a big rise.
Finally, in case the stock moves up right after we created a Covered Call. Nothing to worry, we will still make money because the rise in Future due to rise in underlying will definitely be higher than rise in Call Option.
The profit may be a little less but there will be profit if the underlying moves in our expected direction, which is up.
That is a Covered Call. Simple strategy that helps us reduce our losses and, in some cases, increase our profits. The only risk is the possibility of loss in Profits.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
